On May 18, Neel Kashkari, former interim head of the US Treasury Department's Office of Financial Stability, spoke at Wharton's San Francisco campus. The speech covered his views on the causes of the crisis; the reasons why the Treasury Department had to seek authority to set up a $700 billion bailout program; how that authority was used to keep the financial system from collapsing; and where the economy is headed. After the lecture, Kashkari discussed these issues with members of the audience. The following is a slightly edited transcript of the speech.
Neel Kashkari: Good evening, and thank you, Doug, for that kind introduction. I would also like to thank Wharton for hosting this event today. You know, given the severity and the complexity of the credit crisis, I think it's essential that we have a vigorous dialogue, to really understand the causes of the crisis, learn from it, and make sure that we can prevent these things from happening again. And I think that the Wharton community is ideally suited to contribute to that discussion. So as a Wharton alumnus, it's really a privilege for me to be here with you today.
What I'd like to do tonight is first establish a foundation, by offering some prepared remarks briefly explaining what led to the crisis, why we had to go to Congress to seek unprecedented authority to create a $700 billion program, how we used that authority to prevent a financial collapse, and where we're now headed. But then, what I really want to get to is a discussion. I want to spend the most of the time on Q&A, and hear from you, and have an active dialogue.
The importance of the financial system
Let me begin by reviewing very quickly how the financial system affects every American, and every American family. Banks, as you know, serve as a primary intermediary between borrowers and savers. Americans save for their futures, and for their families. And these savings of individual Americans are combined and made available to other people, and to businesses that need to borrow money for their specific needs. The financial system links millions of individual savers around the country with millions of individual borrowers around the country, through billions of individual transactions. This extraordinarily complex but usually efficient system includes both banks where you and I have our savings accounts, and non-banks, such as financial institutions that provide credit cards and car loans and student loan financing.
Now, this system has developed over our nation's history, and it is built on confidence and on trust. Savers, be they individuals or businesses, need to have confidence in the institutions and the people they entrust with their money. And because no single bank can touch every family or every business, banks must have confidence to lend to each other for the system to work.
Causes of the credit crisis
With that background, let me briefly describe the fundamental causes of the credit crisis. The seeds of the crisis were planted during a decade of benign economic conditions, including low interest rates and low inflation. Financial innovation, which has served the U.S. economy well over the years, also accelerated. Investors gained increasing confidence in the effectiveness of new financial products to diversify and distribute risks. With this perceived reduction in risk, leverage increased across the financial system. Underwriting standards for mortgages weakened as more and more reliance was placed on the value of the home rather than affordability. Homeowners took out ever larger mortgages with little or no down payment and little or no documentation of income. Regulators, investors and homeowners took comfort from the belief that home prices only go up.
As we have learned, that belief was incorrect. To understand the consequence of that miscalculation, consider that the U.S. residential mortgage market is an $11 trillion market. With banks' highly leveraged balance sheets and minimal down payments on home loans, even a minor drop in home prices and rise in defaults can result in a large hit to banks' capital. Large losses can threaten the solvency of financial institutions.
Rooted in housing, this credit crisis is complicated by a number of related factors: First, home prices adjust downward slowly, in part due to homeowners' reluctance to realize losses; most people would rather keep their home than sell for a loss if they can avoid it since it usually is their largest financial asset. Next, this necessary housing correction, which is not over, is setting the pace of the credit crisis. Finally, this slow adjustment makes it difficult to value mortgages and mortgage-backed securities, because investors don't know for sure where the bottom of the housing market is and when it will be reached.
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